06 November 2018
By John Husselbee, Co-Fund Manager HC Verbatim Portfolio Growth Funds
An important part of being a fund selector is keeping up with the industry’s latest innovations and one of the best places in the world to do that over the years has been the annual Morningstar conference.
I was lucky enough to attend this year’s event in Chicago back in June and saw a range of speakers from across the spectrum. As anyone familiar with our investment process will know, one of our core beliefs is that while consistency of performance is ultimately impossible, consistency of approach – at least for our chosen managers – is vital.
With that in mind, one of the most interesting sessions for me focused on Morningstar’s efforts to improve performance measurement, proposing two new metrics called longest underperformance and outperformance periods (LUP and LOP respectively).
As we all know, returns from actively managed funds are compared against pre-selected benchmarks to determine ‘outperformance’. While this seems a straightforward exercise, it is complicated by the fact a fund that ultimately beats its benchmark over a certain timeframe may go through stretches of underperformance within that period. These stretches can be particularly stark if a fund has a strong style bias and the market goes against that approach at particular times.
We can point to several well-known instances of this from the recent past; value-oriented managers were dismissed as out of touch dinosaurs during the excesses of the TMT bubble in the late 1990s, for example.
When looking at its LUP and LOP measures, Morningstar examined a global set of active funds over a 15-year period from January 2003 to December 2017 and found a number of interesting things.
Around two-thirds of the funds analysed —3,790 out of 5,500—beat their benchmarks over the 15-year period but of these, the average LUP ranged from nine to 11 years. What this means in practice is that investors not only needed to pick the right managers but also have the patience to endure long periods of sub-par returns.
The opposite is also true: a fund that ultimately underperforms its benchmark over a 15-year period could well have gone through an eight-year period of outperformance, enticing return-chasing investors to buy the fund, only to be disappointed by subsequent results.
To show the data on this, of 1,710 funds that ultimately underperformed over the 15-year period, 1,164 had an average LOP of 11 years. Again in practice, this mean it would have ultimately have been a mistake to judge a fund’s ability to outperform on a track record as long as 11 years.
Using simulations, Morningstar showed that even a very skilled manager, over a span of 100 years, would underperform his/her benchmark for a period of 20 years at some point during that time.
So what can we take from all this? A key point for us, which chimes with our investment process, is that patience has to be a watchword when it comes to investing – which is increasingly out of step with the short-termism of markets and much of the commentary about them.
As Morningstar concludes, active investing is a long game but many of the standard performance metrics that measure it – which investors continue to rely on when selecting funds despite warnings – are not built around this. Alpha, beta, and information ratio for example all typically use three or five years as their default timeframe but this data shows those periods are too short to evaluate a manager with any degree of confidence. Even stretching it to a decade isn’t going far enough.
For Morningstar, these findings should encourage investors to recalibrate their expectations.
“Asset management firms should perhaps rethink how they structure their bonuses for active managers,” said the group.
“Most importantly, perhaps, investors who have confidence in their pick need a big dose of patience, an investing virtue that has not been emphasised enough. It turns out that even if you have the acumen to pick a good manager, this may be of little avail if your patience fails you.”
While it is very early days for LUP and LOP, I would suggest they could eventually prove to a useful tool in support of our consistency of process focus: as we have long said, we are often buying particular managers to fit a style requirement in our portfolios and therefore want them to keep to that approach.
Baked into that is the understanding that managers with a strong style bias can go through lengthy period of underperformance but we want to see consistency of process whatever the market is doing in the background.
We select funds and managers that complement each other in terms of investment style. It is key, therefore, that managers have a track record of maintaining their style and do not drift away from it: if they do, this is a reason for us to sell out.
The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The portfolios' investments are subject to normal fluctuations and other risks inherent when investing in securities. Verbatim Asset Management has taken due care and attention in preparing this document, which is solely for the use of professional advisers. Verbatim cannot be held responsible for any inaccuracies arising out of information detailed within and will not accept liability for any loss arising out of or in connection with its use.